The Counter-Intuitive Investor

When Do “Animal Spirits” Drive the Stock Market?

The term “animal spirits” was coined by John Maynard Keynes, highly regarded early twentieth century British economist. He used it to describe the buying behavior of investors who showed a herd-like mentality of irrational exhuberance whenever stocks were in a strong bull market. When the stock market continues to advance and investors continue buying overvalued stock while making more and more money (on paper, anyway), just about everyone’s a genius and feels like Superman. Keynes’ animal spirits can be thought of as “testosterone on steroids”(i.e., my phrase).

The idea that “I’m truly blessed” and “must have a unique gift” as an investor begins to take hold. This feeling of stock picking omnipotence is an inherently human foible which seems to especially be present as the stock market continues to reach new highs. (I would imagine animal spirits are present in other non-stock related human activity; for example, in war-especially in the early stages for the side that’s winning.)

The two questions investors must ask themselves are as follows: (1) “At what point does this phenomenon of group-think excessive buying mentality and the resulting irrational investor buying activity start to significantly jump-start market prices by themselves, leading to levels over and above true market value? True value, of course, at any point in time, is always debatable itself. But realizing that such a number exists in reality, to what extent do these animal spirits start to have their own unique effect on the stock market? And (2) “Does the answer to the first question matter at all to the long term investor?” Let’s examine both questions and then consider the most advantageous response for the long term investor.

Animal Spirits start to make their influence known in the early stages of a bull market (stocks continue going up). As the stock market first elevates above true value (again, a debatable number), some of the rise can be attributed to simple math related investor miscalculation of true value on the high side. But, then we have the “growth stock” phenomenon taking it’s turn pushing up prices. This is the stage of a bull market when larger numbers of stocks are afforded a higher P/E ratio (and therefore, higher price level), based on their projection of a higher growth rate than average. These higher growth rate projections seem to fall right in, synergistically, with increasing levels of animal spirits. This combination “egging each other on”, leads to higher levels of investor overconfidence

The timing of the arrival of the first nascent animal spirits is determined by both fundamental and psychological factors. How far from true value was the market before it began its new bull move? Was it significantly undervalued to begin with, or possibly still overvalued. Maybe it was at or close to true value. How long was the market previously in a bear market (where stocks continue going lower), if, in fact, it was? Did a long time period of undervaluation depress overall investor mood and confidence to the extent that it now takes longer for a new level of confidence and animal spirits to take hold? This is certainly what occurred after the crash of 1929 led to the “Great Depression”, lasting a decade. Finally, did investors lose a lot of money in the last crash?

After severe recessions or depressions, the resulting bear markets (in extreme cases) may take up to a generation, although usually in much less time, for investors to forget. But, forget they do. Then a new generation of investors, or the same older investors, need to learn stock market lessons all over again. But, I digress. Investors slowly come back, as confidence slowly returns.

The stock market is ruled psychologically, by fear and greed. Fear is experienced as investors begin to lose larger amounts of money (at least on paper) during the bear part of the stock market cycle. Greed is what investors feel during the bull phase of the cycle. I don’t like the term “greed”as a description of investor psychology and behavior during strong extended bull markets. If it is greedy to want to make money in the stock market as it continues it’s ascent, then why do we invest at all? Is an Investor supposed to stop and sell his stock as soon as he or she feels it’s fairly valued? No money would ever be made this way-also not very good for all those 401Ks and IRAs.

In many cases, however, I would have to say “stupidity” is probably an accurate word if an investor continues “all in” (100% invested in stock), as the market becomes increasingly and irrationally overvalued. He or she should always have a large enough cash and/or bond position during an extended bull market.

The trick is to have enough money in cash to buy stock (index funds) when the market starts heading down again. But again, I digress. The answer to the first question is “Yes”! Inevitably, as animal spirits gain market power, more investors get caught up in this irrational exuberance, and the result is a stock market bubble, almost every time! Animal spirits, once a certain level is reached, drive the market, leading, in just about every case to a bubble. So, indeed, this phenomenon, greed, irrational exuberance, animal spirits, or whatever you want to call it, will, by itself, jump the stock market well above its true value, almost every time.

Now, the second question concerns the response of the long term investor to these animal spirit-fueled stock market bubbles. What should he or she do? The answer is “nothing!” Nothing, except take advantage of the other side of the stock market cycle, by having enough cash available to buy stock index funds (the reason to buy index funds is explained in a previous post: “The Indespensable Index Fund) as the market enters the new bear phase, whenever that happens.

Bull markets can last years, sometimes three to five years and even longer. Some money should always be in stock, regardless. But the trick is to reduce the stock percentage of the portfolio, thereby increasing the bond-cash portion at some point during the bull phase of the cycle, in order to be prepared to buy during the bear phase (lasting, on average, eighteen months).

I am now forced to digress (voluntarily, actually) from the main theme of this post in more detail: The strategy of ‘buying when others are selling, and selling when others are buying’ is a counterintuitive strategy in the very real sense of NOT following the investor’s initial common sense reaction. In his gut, the average investor wants to sell when others are selling, and buy when others are buying. There is comfort, if not profit, in going along with the crowd where stock and bond market investing is concerned. However, most large profits from the stock and bond markets are gained by doing the opposite, investing against the crowd- counterintuitively.

It is vitally important for an investors financial success to think and act counterintuitively (that which does not at first seem true or correct). Of course it is necessary to have a definite strategy involving the specific buy and sell decisions, over and above the right timing of such stock and bond purchases and sales. I highly recommend (no surprise) my Strategic Stock Accumulation Strategy. If you read the steps to implement the SSA Strategy, you should be able to understand its success potential for your future financial security. The description and link to the strategy are on my website, stephenrperry.com.

How does the investor know when to start “lightening up” on stock (again, index funds) during the bull phase? One approach recommended by financial advisors is Asset Allocation along with Proportional Rebalancing (PR). My strategy (SSA), as outlined in my book, “How to Make a Fortune during Future Stock Market Crashes with Strategic Stock Accumulation” has proven superior. I personally back-tested and compared SSA with PR and also an All-Stock portfolio over six different time periods in at least six different stock market crashes. SSA proved superior as a long term strategy over almost every time period tested.

The back-tested results for SSA are all on this website, stephenrperry.com. You can decide what strategy was most effective for a long term investor after studying the graphs and 16 column tables, which document and confirm the graphs. At any rate, the long term investor need not worry about the highs and lows of the stock market. Follow a proven rational disciplined strategy, and don’t deviate from it. That’s always the best strategy.